Less is Still More in China

Pollution is suffocating China's cities as soot from coal-dependent businesses fills the air. The government has pledged to reduce its reliance on coal, but don't be fooled. The still maturing nation will continue to increase its coal use for years to come.

It's the "Pi" that countsTo understand why China will use more coal think about a pie. An eight inch pie has about 12.5 square inches of yummy goodness in it. If you cut it into quarters, each piece has about four square inches of that goodness. If you baked a 12 inch pie, it would have nearly 19 square inches of waist bursting calories and a quarter slice would contain 4.75 square inches of them.

Bigger pie, bigger slice—not rocket science. But if those two pies are China's energy generation and the quarter slice represented coal's share, you can quickly see the issue -- coal's actual share in 2012 was more like 66%, but who eats that much pie in one sitting? Even if coal's share stays the same or declines a little, China will be using more because the energy pie is expanding.

Benefiting todayThis big picture is why some environmental groups are suggesting that China isn't doing enough by pledging to reduce coal's use to 65% of the total by 2017. In other words, China's big coal suppliers will benefit even if coal's growth is "limited." Export giant Indonesia will benefit, but so too will diversified miners Rio Tinto and BHP Billiton , and coal-focused Peabody Energy . All three have material operations in strategically located Australia.

Rio Tinto and BHP Billiton generate far more revenue from their iron ore divisions than from coal, but the two commodities are linked—metallurgical coal is used to make steel. So not only will this pair benefit from demand for coal for generating electricity, but also from China's continued industrialization. That's a good thing, too, since BHP Billiton generates just under 30% of its sales from China and Rio just under a third. The country is, bar far, the single largest customer for both.

Peabody is also in the Australian met market, which makes up just over a quarter of its business. However, it only does coal. While the diversified miners have generally more stable businesses, Peabody has more turnaround potential when coal markets start to rebound.

Coal at home and abroadPeabody also gets around 15% of revenue from Australian thermal coal, which has to compete head to head with Indonesia's largely thermal exports. That said, Australian dollar weakness has made U.S. thermal and met coal less competitive, so U.S. coal giant Peabody is still getting the good end of the stick.

That can't be said for domestic coal players like Arch Coal and Alpha Natural Resources , which mine thermal and met coal domestically. Both companies have been looking to the export markets to make up for coal's declining fortunes in the United States, which hasn't worked out so well this year.

For example, Arch has idled two mines and delayed a project in its met operation because of weak met markets. Its met coal business sold over 20% less coal in the second quarter than it did last year. Peabody shipped nearly 15% more met coal out of Australia year over year in the second quarter. And when U.S. thermal coal is competitive again, it will be exporting right along with Arch and Alpha.

China's still callingWhile percentages say China is holding the line on coal, a growing energy pie means that's just smoke and mirrors. Peabody, BHP, and Rio all serve China's growing coal appetite via their well-positioned Aussie operations. Longer term Chinese demand is even likely to make Arch and Alpha's export wishes come true, eventually.

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